Trade Deficits: Bad or Good?

International Finance

As usual in economics, there are several different views of trade deficits. Depending on who you talk to, they are bad, good, both (depending on the situation), or immaterial. However, few economists argue that trade deficits are always good.

Economists who consider trade deficits to be bad believe that a nation that consistently runs a current account deficit is borrowing from abroad or selling off capital assets—long-term assets—to finance current purchases of goods and services. They believe that continual borrowing is not a viable long-term strategy, and that selling long-term assets to finance current consumption undermines future production. (If this reminds you of the discussion about federal budget deficits and the national debt, that's no accident. The mechanisms at work are similar.)

Labor unions oppose trade deficits because they believe that when imports exceed exports, jobs are being lost to overseas workers, or soon will be. On the surface, it seems a reasonable argument, but the data on trade deficits and unemployment don't support it. In the late 1990s, when the trade deficit reached record highs, unemployment dropped to its lowest level in three decades.

Some economists who oppose trade deficits see them as a symptom, rather than a cause, of trouble, specifically bad central bank policy. They believe that trade deficits arise from loose monetary policy. A rapidly growing money supply boosts demand, including demand for imports. This has two effects: First, it generates inflationary pressure, some of which is “exported” to other nations, in the form of higher prices over there. Second, it directs too much investment in other nations into export industries. These nations' economies then suffer when America hits a recession and imports less.

Economists who consider trade deficits good associate them with positive economic developments, specifically, higher levels of income, consumer confidence, and investment. They argue that trade deficits enable the United States to import capital to finance investment in productive capacity. Far from hurting employment, they believe that trade deficits financed by foreign investment in the United States help to boost U.S. employment.

Some economists see trade deficits as mere expressions of consumer preferences and as immaterial. These economists typically equate economic well being with rising consumption. If consumers want imported food, clothing, and cars, why shouldn't they buy them? That range of choices is part of a successful economy.

Perhaps the best view of trade deficits is the balanced view. If a trade deficit represents borrowing to finance current consumption rather than long-term investment, or results from inflationary pressure, or erodes U.S. employment, then it's bad. If a trade deficit fosters borrowing to finance long-term investment or reflects rising incomes, confidence, and investment—and doesn't hurt employment—then it's good. If a trade deficit merely expresses consumer preferences rather than these phenomena, it is immaterial.

EconoTip

The U.S. dollar is among the world's most stable currencies, backed by a strong economy with low inflation. Therefore many foreigners hold their savings in U.S. dollars. Sometimes, entire countries adopt U.S. currency as their own currency. These officially “dollarized” nations include Panama, Ecuador, El Salvador, and Guatemala. The dollar is also widely used in the Bahamas, Cambodia, and Haiti.

But what about the effect on GDP? Shouldn't Americans worry when net exports are negative and GDP is smaller than it otherwise would be?

Most mainstream economists believe that because the current account deficit is offset by foreign investment in the United States, the effect on GDP is negligible. The security of the U.S. economy and the U.S. dollar make investments in U.S. productive capacity and in U.S. corporate and government securities quite attractive. So as long as the trade deficits are financed by foreign investment and the dollar is not overly weakened by them, then GDP will be fine.

So, given the size of the U.S. economy and the benefits of foreign investment in the United States, the effect of trade deficits on GDP is minimal. This is particularly true when compared with the effect of other, more easily influenced factors, such as U.S. monetary policy. It's best to view trade deficits in the context of growth, unemployment, inflation, and other measures of economic performance. The size of the trade deficit itself, and even its trend, reveals very little about the condition of the U.S. economy.